Back Matter

Appendix. Cambodia: Effects of Changes in the U.S. Federal Funds Rate on Macroeconomic Variables

Macroeconomic literature identifies two main channels through which monetary policy shocks could be transmitted between countries. The first channel is the Trade channel. In this channel, monetary policy tightening in a trading partner country (country A) can result in dampened economic activity in that country leading to lower demand for imports that translates to lower exports in the trading partner country (country B). The second channel is the Financial channel. When capital is mobile between two countries, the financial channel tends to be important. Monetary policy tightening in country A relative to country B can attract capital to country A given the higher rate of return due to higher interest rates. The importance of these channels on Cambodia is explored below using a vector autoregression model (VAR).

Vector autoregression model

The VAR approach has gained popularity in the economic literature since its introduction by Sims (1980) as a tool to assess the transmission mechanism. In a general form, the VAR(p) model is as follows:

yt=c+β1yt1+β2yt2++βpytp+μt

Where c is an nx1 vector of constants, is βi an n by n matrix of betas for i=1,2,…p and εt is an n by 1 vector of error terms. The error terms are serially uncorrelated and the mean of each error vector is the zero vector, the covariance matrix between the error terms for a given point in time is positive definite and the correlation between the error vectors is zero across time (i.e., there is no serial correlation among the error vectors).

The VAR model is estimated on quarterly data for Cambodia for the period Q1 1995 to Q2 2009. The choice of variables in the model is motivated by various theories of the transmission mechanism. While the traditional Mundell-Fleming-Dornbusch model (see Dornbusch, 1980,) establishes macroeconomic aspects of transmission in small open economies providing the basis for the trade channel, the model itself has been found in empirical work to be insufficient to explain the full transmission. Therefore, there have been extensions in the literature including that by Obstfeld and Rogoff (1995) by incorporating the microeconomic aspects of transmission, especially the incorporation of monetary shocks and therefore the important role of interest rates, which help provide the basis for the financial channel. The variables incorporated in the VAR model are: the federal funds rate (for U.S. monetary policy shock); the bilateral nominal exchange rate; the trade balance helps to capture the impact on and significance of the trade channel, broad money, domestic lending and deposit interest rates (to help test the significance of the financial channel); inflation; and the output gap (for real economy impact). The output gap is measured as the deviation of real GDP from the historical trend (measured through the Hodrick-Prescott filter). A positive output gap implies that real GDP is above its potential and therefore can have inflationary effects and would warrant tightening domestically.

Tests on variables and the model

All variables were found to be integrated of order 1 (I(1)) except the output gap variable, which was found to be integrated of order 0. This means that I(1) variables need to be differenced once to make them stationary. The residuals from the VAR are found to be stationary (Appendix 1). The VAR was estimated with 2 lags given that this number of lags minimizes the Akaike information criterion, which helps measure the goodness of fit of the model.

Impulse response functions

The response of variables to the shock in the federal funds rate are identified in the VAR using the Cholesky decomposition. The Cholesky method requires identifying the chain of reaction (or the ordering of variables) starting from the exogenous variable to the most endogenous. The ordering used is from the federal funds rate (dfedfundsr), to the exchange rate (dlexchr), to the trade balance (dtradeb), to broad money (dlbm), to deposit rates (drdepr), to lending rates (drlendr), to the output gap (ygap), and lastly inflation (dlcpi). Oil prices enter exogenously in the model to help capture the effect of commodity prices. In the acronyms of the variables, d stands for the differencing and l means that the variable has been logged.

It appears that financial sector variables (specifically the lending and deposit rates) have a stronger reaction to shocks in the federal funds rate compared to the trade balance. The results can be summarized as follows:

  • A standard deviation shock to the federal funds rate (an increase of about 0.3 percent) results in an increase in the lending rates of about 0.4 percent and a 0.46 percent increase in deposit rates as local banks attempt to minimize the spread between domestic and foreign interest rates. The impact on domestic interest rates occurs within the first quarter of the shock to the federal funds rate, with a larger impact occurring in the second quarter. However, as the lag of the impact increases, domestic interest rates decline (between five to seven months) probably reacting at this point to lower demand for loans as the Cambodian economy contracts.

  • A shock to the federal funds rate appears to result in an increase in the Cambodian trade balance (by about 0.1 percent following a 0.3 percent shock in the federal funds rate) within a quarter and a negative effect in two quarters. The immediate positive impact may be reflecting a stronger contractionary impact on imports in Cambodia, since as domestic interest rates also respond with an increase, they contribute to an overall contraction. However, the trade balance worsens somewhat in the third quarter, indicating the contractionary effect on exports as external U.S. demand has had time to respond to the initial federal funds rate shock.

  • Response of the exchange rate is rather small with the riel depreciating against the U.S. dollar. This is not surprising due to high dollarization in Cambodia, which implies loss of flexibility in exchange rate policy. It has been contended in the literature that highly dollarized economies tend to adjust through goods and factor markets as well as financial markets and not necessarily through the exchange rate (de Zamaróczy and Sopanha, 2003).

  • A shock to the federal funds rate results in a decline in output and inflation in Cambodia reflecting a contractionary effect of U.S. monetary policy (and therefore lower liquidity into Cambodia) as well as the contractionary effect of domestic rates within the first quarter. However, as domestic interest rates decline in the following months, domestic output picks up and inflation rises a quarter later.

Variance decompositions

Another way to analyze the dynamics of the VAR is through forecast error variance decompositions. The variance decompositions help determine the relative importance of the shock variable to fluctuations in the response variables in the model. Shocks to the federal funds rate contribute about 25 percent of variation in the financial variables, whereas they contribute about 5 percent of the variation in the trade balance. On real economy variables, the federal funds rate contributes to about 15 percent of variation in the output gap and about 23 percent variation in Cambodian inflation. The higher impact on the real economy as compared to the trade channel likely reflects the double impact of the financial and the trade channels on overall economic activity.

Appendix Figure 1:
Appendix Figure 1:

Residuals

Citation: IMF Working Papers 2011, 049; 10.5089/9781455218936.001.A999

Appendix Figure 2:
Appendix Figure 2:

Impulse Responses

Citation: IMF Working Papers 2011, 049; 10.5089/9781455218936.001.A999

Note: The red dotted lines are response standard errors.
Appendix Figure 3:
Appendix Figure 3:

Cumulative Pass-Through Coefficients of the Federal Funds Rate

Citation: IMF Working Papers 2011, 049; 10.5089/9781455218936.001.A999

Appendix Figure 4:
Appendix Figure 4:

Variance Decompositions

Citation: IMF Working Papers 2011, 049; 10.5089/9781455218936.001.A999

References

  • Baliño, T., A. Bennett, and E. Borensztein, 1999, Monetary Policy in Dollarized Economies, IMF Occasional Paper No. 171, (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Berg, A., and E. Borensztein, 2000, “Full Dollarization: The Pros and Cons,” IMF Economic Issues No. 24, (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Bogetić, Ž., 2000, The Calculus of Full Dollarization, Central Banking, Vol. XI, No. 2, November, pp. 4557, (United Kingdom).

  • Bufman, G., and L. Leiderman, 1993, Currency Substitution under Nonexpected Utility: Some Empirical Evidence, Journal of Money Credit, and Banking. Vol. 25, No. 3 (August 1993, Part I), The Ohio State University Press.

    • Crossref
    • Search Google Scholar
    • Export Citation
  • Chang, R., 2000, Dollarization: A Scorecard, Economic Review, Federal Reserve Bank of Atlanta, issue Q3, pages 112.

  • Coe, D. T., I. Lee, W. F. Abdelati, R. H. Eastman, S. Ishikawa, A. Lopez-Mejia, S. Mitra, S. Munoz, K. Nakamura, N. Rendak, and S. Yelten, 2006, Cambodia: Rebuilding for a Challenging Future (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • de Zamaróczy, M., and S. Sopanha, 2002, “Macroeconomic Adjustment in a Highly Dollarized Economy,” IMF Working Paper No. 92, (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • de Zamaróczy, M., and S. Sopanha, , 2003, Economic Policy in a Highly Dollarized Economy: The Case of Cambodia, IMF Occasional Paper No. 219, (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Dornbusch, R., (1980), Open Economy Macroeconomics, Basic Books (New York).

  • Erasmus, L., J. Leichter, and J. Menkulasi, 2009, “Dedollarization in Liberia—Lessons from Cross-country Experience,” IMF Working Paper No. 09/37, (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Galindo, A., L. Leiderman, 2005, “Living with Dollarization and the Route to Dedollarization,” Inter-American Development Bank Working Paper No. 526, New York.

    • Search Google Scholar
    • Export Citation
  • Goux, J., and C. Cordahi, 2007, “The International Transmission of Monetary Shocks in a Dollarized Economy,” GATE Working Paper, Groupe d’Analyse et de Théorie Économique, France.

    • Search Google Scholar
    • Export Citation
  • Herrera, L., and R. Valdés, 2005, “De-dollarization, Indexation and Nominalization: the Chilean Experience,” The Journal of Policy Reform, Vol. 8, No. 4, 281312, December.

    • Crossref
    • Search Google Scholar
    • Export Citation
  • Humpage, O., 2002, “An Incentive-Compatible Suggestion for Seigniorage Sharing with Dollarizing Countries,” Discussion Paper No. 4, June, (Cleveland Federal Reserve Bank).

    • Search Google Scholar
    • Export Citation
  • Ize, A., and E. Yeyati, 2005, “Financial De-dollarization: Is it for Real?IMF Working Paper No. 187, (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Kokenyne, A., J. Ley, and R. Veyrune, 2010, “Dedollarization,” IMF Working Paper No. 188, (Washington: International Monetary Fund).

  • Menon, J., 2008, “Cambodia’s Persistent Dollarization: Causes and Policy Options,” Working Paper Series on Regional Economic Integration No. 19, Asian Development Bank.

    • Search Google Scholar
    • Export Citation
  • Obstfeld, M., and K. Rogoff (1995), “The Mirage of Fixed Exchange Rates,” NBER Working Paper Series, No. 5191 (National Bureau of Economic Research).

    • Search Google Scholar
    • Export Citation
  • Powell, A., and F. Sturzenegger (2000), “Dollarization: The Link between Devaluation and Default Risk,” Business School, Universidad Torcuato Di Tella.

    • Search Google Scholar
    • Export Citation
  • Prasso, S., 2001, “The Riel Value of Money: How the World’s Only Attempt to Abolish Money Has Hindered Cambodia’s Economic Development,” Asia Pacific Issues No. 49, East-West Center.

    • Search Google Scholar
    • Export Citation
  • Reinhart, C., K. Rogoff, and M. Savastano, 2003, “Addicted to Dollars,” NBER Working Paper 10015 (Cambridge, Massachusetts: National Bureau of Economic Research).

    • Search Google Scholar
    • Export Citation
  • Rennhack, R., and M. Nozaki, 2006, “Financial Dollarization in Latin America,” IMF Working Paper No. 7, (Washington: International Monetary Fund).

    • Crossref
    • Search Google Scholar
    • Export Citation
  • Sims, C. A., 1980, “Macroeconomics and Reality,” Econometrica, Vol. 48, No. 1, January, pp. 148.

  • Unteroberdoerster, O., 2002, “Foreign Currency Deposits in Vietnam—Trends and Policy Issues,” Vietnam: Selected Issues and Statistical Appendix, IMF Staff Country Report No. 02/5 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
1

Comments from and discussions with Olaf Unteroberdoerster, Masahiko Takeda, and Kenneth Kang are gratefully acknowledged. The paper has also benefitted from discussions at the National Bank of Cambodia.

2

Banks are required to hold reserves in U.S. dollars (for foreign currency deposits) and in riel (for riel deposits). As of end-November 2010, the required reserve ratio on foreign currency is 12 percent, while that on riel is 8 percent. Required reserves are remunerated at one-half the Singapore Interbank Offered Rate (SIBOR).

3

Lao P.D.R. and Bangladesh were also assessed, but produced insignificant results given that they have low currency in circulation.

4

Moreover, the relatively fixed exchange rate conflicts with the need to facilitate adjustment to asymmetric shocks as well as to protect official reserves, given the limited lender-of-last resort capability under dollarization.

Dollarization in Cambodia: Causes and Policy Implications
Author: Ms. Nombulelo Braiton